International Finance

Yulia B. Ilina
Asc. Prof.
Department of Finance and Accounting
It would take a revolution to
overthrow the greenback (handout)
 How the replacement of the US dollar as a
world reserve currency could affect
international financial environment? Why it is
said that other countries could benefit from it?
 Why the USD could hardly be replaced?
 Course content
 Topic 1. Introduction. Goals of International Financial
Management. Overview of International Financial
Markets. International Parity Relationships and
Exchange Rate Behavior.
 Topic 2. Foreign Exchange Market and Arbitrage
Activities. International Money Market.
 Topic 3. International Banking.
 Topic 4. International Capital Markets.
 Topic 5. Corporate Governance around the World.
 Topic 6. International Portfolio Investments
 Topic 7. Futures and Options on Foreign Exchange.
 Topic 8. Currency and Interest Rate Swaps.
 Topic 9. Managing Currency Exposure with Derivatives.
Required textbooks
 Eun C., Resnick B. G. International Financial
Management. 4-th ed. McGraw-Hill, 2007
 Eiteman D.K., Stonehill A.I., Moffet M.H.
Multinational Business Finance. 11-th ed.
Pearson Education, Inc., 2007

Additional recommended textbook:

Shapiro A. Multinational Financial
Management. 8-th ed. Wiley, John & Sons,
Inc., 2006.
Grading system

Element Weight
1. Final exam 60%
2. In-class tests 15%
3. In-class group work 5%
4. In-class participation in 10%
Citibank case studies
5. Home assignments 10%
TOTAL 100%
 Current evaluation
 In-class assignments: tests, group work assignments,
Citibank case studies
 Home assignments: exercises
 In-class tests (30-40 min) are closed-book assignments
that combine multiple-choice questions as well as open
questions, based on cases discussed, and problems
(numerical exercises). In case of missing (failure) the test,
missing other in-class assignments they are not to be
repeated or substituted by other types of activities.
 The mid-term grading (required for Russian students –
«аттестация» (rus.)) is made on accumulated basis.
Student has to accumulate no less than 50% in total for all
types of assignments by the grading period (date).
 Home assignments should be submitted as scheduled.
Assignments submitted later are not accepted.
Final evaluation (exam)

 Final evaluation is exercised by written open-

book exam (90 min).
 Exam includes mini-tests, problems, open
questions.
 Topic 1

Introduction. Goals of International Financial

Management. Overview of International
Financial Markets. International Parity
Relationships and Exchange Rate Behavior.
Key points
 Goals for international financial management
 The structure of international financial
environment, overview of international
financial system
 Purchasing Power Parity and the Law of One
Price
 Real and nominal exchange rates
 Fisher Effect
 International Fisher Effect
 What is a multinational corporation (MNC)?

A multinational corporation (MNC) can be defined

as a business firm incorporated in one country that
has production and sales operations in several other
countries. MNCs obtain financing from
international financial markets.
Why multinational  Searching lower cost
enterprise needs financing alternatives
international (factors of production
financial costs)
environment?  Searching investment
opportunities globally
 Quarter's Top Funds Had a Global Flavor ---
U.S. Did Well, but International Did Better
(handout)
Big slide, big rebound
 What are reasons for International funds
outperformance? Are any favorable factors
underlying emerging markets current
performance?
 What could be the prospects of international
investments performance?
Main difficulties
managers face in Doing business in different
the global currencies:
financial exchange rate risk
marketplace
Different government
regulations, tax laws,
business practices, political
environments
What is one of the most important financial
aspects of international business?

The impact of shifting exchange rates and

what companies (individuals) can do to
protect themselves against adverse
exchange rate movements.
Exchange rate
 The price of one country’s currency
expressed in terms of another country’s
currency
Exchange rate uncertainty is very important
factor in international investments. Why?

returns on foreign investments and

revenues from international
transactions are directly affected by
currency movements, because they
must be translated from foreign to
domestic money
indirectly they are influenced by reaction
of asset prices to exchange rate
adjustments
Earnings: At the Mercy of a
Mercurial Dollar (handout)
 Comment the following:
 “Investors in U.S. stocks were
celebrating the weak U.S. dollar last
year”
 “While their domestic market was in
recession, U.S. firms could report big
sales figures from abroad”.
How is international financial management
different from domestic financial management?

 Foreign Exchange Risk

 Political Risk
 Market Imperfections
 Expanded Opportunity Set
How is international financial management
different from domestic financial management?

Foreign Exchange Risk

 The risk that foreign currency profits may
evaporate in real terms due to unanticipated
unfavorable exchange rate movements
How is international financial management
different from domestic financial management?

 Political Risk
Sovereign governments have the right to
regulate the movement of goods, capital, and
people across their borders.
How is international financial management
different from domestic financial management?

 Market Imperfections
 Legal restrictions on movement of
goods, people, and money
 Transactions costs
 Shipping costs
 Difference in taxation
Global imbalances (handout)
 Why Asian governments try to prevent their
currencies from strengthening?
 Explain the following: The IMF's charter
forbids members from "manipulating
exchange rates . . . to gain an unfair
competitive advantage over other members".
Why MNC is “a gift of market
imperfections”?
 Why Toyota placed its production in US?
 In Russia?
The Example of Nestlé’s Market
Imperfection
 Nestlé used to issue two different classes of common
stock: bearer shares and registered shares.
 Foreigners were only allowed to buy bearer shares.
 Swiss citizens could buy registered shares.
 The bearer stock was more expensive.
 On November 18, 1988, Nestlé lifted restrictions
imposed on foreigners, allowing them to hold
registered shares as well as bearer shares.

What happened with share prices?

 Nestlé’s Foreign Ownership Restrictions
(October-November, 1988)

12,000

10,000
Bearer share
8,000
6,000
SF

4,000
Registered share
2,000

0
11 20 31 9 18 24
The Example of Nestlé’s Market
Imperfection
 Following this, the price spread between the two
types of shares narrowed dramatically.
 Foreigners holding Nestlé bearer shares were
exposed to political risk in a country that is widely
viewed as a haven from such risk.
 The Nestlé episode illustrates both the importance of
considering market imperfections and the peril of
political risk.
How is it related to international
finance?
The World Bank group is set to launch a $5.5bn
initiative to raise funds to buy distressed assets from
banks in emerging and developing markets in a bid to
clean up their balance sheets and free up credit
flows.
The move came as the International Monetary Fund
warned yesterday that rising losses on loans were
likely to strain bank balance sheets in emerging
Europe "for years to come", saying non-performing
loan ratios could peak as high as double their current
level.
How is it related to international
finance?
 Last fall, Berkshire invested billions in
General Electric Co. and Goldman Sachs to
help those venerable companies raise capital.
Berkshire invested $3 billion in preferred GE
shares and $5 billion in preferred Goldman
shares, and both companies agreed to pay
Berkshire a 10 percent dividend.
How is it related to international
finance?
 Cameco Corp. said late Friday its fourth-
quarter earnings fell by nearly half as the
world's largest uranium producer recorded
unrealized losses on financial instruments.
 Goals for International Financial
Management
 What goal should the effective global manager be
working toward?
Maximization of shareholder wealth?
or
Other Goals?
Problem. How is it related to
international finance?
A working group of French chief executive officers
was set up by the Confederation of French Industry
(CNPF) and the French Association of Private
Companies (AFEP) to study the French corporate
governance structure. The group reported the
following, among other things “The board of directors
should not simply aim at maximizing share values as
in the U.K. and the U.S. Rather, its goal should be to
serve the company, whose interests should be clearly
distinguished from those of its shareholders,
employees, creditors, suppliers and clients but still
equated with their general common interest, which is
to safeguard the prosperity and continuity of the
company”.
Evaluate the above recommendation of the working
group.
Solution
The recommendations of the French working
group clearly show that shareholder wealth
maximization is not a universally accepted
goal of corporate management, especially
outside the United States and possibly a few
other Anglo-Saxon countries including the
United Kingdom and Canada. To some
extent, this may reflect the fact that share
ownership is not wide spread in most other
countries. In France, about 15% of
households own shares.
Maximize Shareholder Wealth
 Long accepted as a goal in the Anglo-Saxon
countries, but complications arise.
Who are and where are the
shareholders?
In what currency should we maximize
their wealth?
 Other Goals

 In other countries shareholders are viewed as merely one

among many “stakeholders” of the firm including:
 Employees
 Suppliers
 Customers
 In Japan, managers have typically sought to maximize the
value of the keiretsu—a family of firms to which the
individual firms belong
Peter Drucker suggestions
 to be successful, multinational corporations
must work to exploit global markets;
 exchange rates are inevitably unstable, and
attempting to predict them is foolish;
 not hedging against exchange rate
fluctuations is equivalent to speculating;
and
 corporate losses can’t be blamed on market
volatility.
Emergence of Globalized
Financial Markets
 Deregulation of Financial Markets
coupled with
 Advances in Technology
have greatly reduced information and
transactions costs, which has led to:
 Financial Innovations, such as
 Currency futures and options
 Currency swaps
 Multi-currency bonds
 Multi-currency loans
 Cross-border stock listings
 International mutual funds
etc.
 Global Capital Markets
 The United States has one of the most
developed capital markets in the world, but
foreign markets are becoming more
competitive, and they are often willing to try
more innovative ways to do business
 International Financial Environment

International Basic Concepts in

Financial System International Finance

International Money International International International Theories of

Financial Markets Financial Institutions Parity Conditions Financial Markets
Behaviour
International Financial System
 Money
 Markets
 Institutions
 International Money

International Financial System

International International International

Money Financial Markets Financial Institutions

International Exchange rates

Monetary System

Exchange Rate Evolution of International Exchange Rate Exchange Rates

Arrangement Monetary System Equilibrium Determinants
 International Financial Markets

International financial System

IM International IFI
Financial Markets

Foreign Exchange Markets International Money International

(Forex) and Capital markets Derivatives
Markets

Immediate Forward International International

Delivery Market Market Money Capital
(spot market) Market Market
 International financial System

IM International IFI
Financial Markets

Foreign Exchange Markets International Debt International

(Forex) and Equity Markets Derivatives
Markets

Immediate International International Options

Delivery Market Debt Equity
(spot market) Market Market

Forward Futures
Bonds Stocks (shares)
Market
(corporate, government
eurobonds)

Loans/ ADRs Swaps

Deposits

Notes

Bankers
Acceptances

Commercial
Papers
World finance: Liquid fuel (home
reading for the class 2)
 What are most profitable financial market
sectors today?
 What is pessimistic about the current
situation?
World finance: Liquid fuel
International Parity Relationships and
Exchange Rate Behavior
 Key Points
 Purchasing Power Parity and the Law of One Price
 Real and nominal exchange rates
 Fisher Effect
 International Fisher Effect
 Foreign exchange quotations
 Forward rates, forward premiums and discounts
 Interest Rate Parity: covered interest arbitrage,
uncovered interest rate parity
 The relationship between the forward rate and the future
spot rate. Forward rate as an unbiased predictor. An
integrative look at the International Parity conditions.
 International Parity Conditions

The economic theories that link exchange rates,

price levels and interest rates together are
called international parity conditions
(relations)
 International Parity Conditions

Why is it necessary for companies and

investors to have an understanding of IPCs?

It is important to understand forces driving

exchange rate changes, as changes affect
investment and financing opportunities
 International Parity Conditions

When the market can be said to be in

equilibrium?

When no profitable arbitrage opportunities

exist
What is the law of one price?
If identical products or services can be sold in
two different markets, the product’s price
should be the same in both markets (if
frictions or costs of moving the products or
services between markets do not exist)
 Links spot exchange rates and inflation.
 Exchange rate between domestic currency and
any foreign currency will adjust to reflect changes
in the price levels of the two countries.
 Currencies with high rate of inflation should
devalue relative to currencies with lower rates of
inflation.
Spot and Forward Rates
Spot rate - the present exchange rate for
immediate delivery
Forward rate - the present exchange rate for
deliveries of currencies in the future
Exchange rates between two currencies will
equal the ratio of the price indexes between
the countries (absolute version of PPP). The
spot exchange rate is determined by the
relative prices of similar baskets of goods.

The absolute version of purchasing power parity

(PPP):
S = P$/P£.
Example. The “Hamburger Standard”

Assumption: Big Mac is identical in all countries listed.

The “hamburger standard” serves as one form of
comparison of whether currencies are trading at markets
rates close to the exchange rate implied by Big Macs in
local currencies.
 Big Mac in Switzerland costs SFr 6.50, in
USA $ 3.54.
 PPP exchange rate:
6.50/3.54 = SFr 1.84/$

The actual exchange rate was SFr 1.16/$

SFr was overvalued by:

(1.84-1.16)/1.16 = 0.59 or 58,6%

Exercise
 Assume, Big Mac in Russia rose to the price
of 75 rub. At the same time Ruble went down
to 34.76 Rub/$
 Estimate the over (under) valuation of the
Russia Ruble according to Big Mac Index.
A less extreme form of this principle would be
that with relatively efficient markets the price
of a basket of goods would be the same in
each of several markets. So we replace the
price of a single product with a price index,
for example: yen
PI
S $
PI
Relative PPP:
Changes in the differential rates of inflation
between two countries will be offset by equal,
but opposite changes in the future spot
exchange rate
 Relative PPP:
S1  S 0   h   f 


S0  1 f 
 
S1 — expected future spot rate at time period
1
S0 — current spot rate
f - expected foreign country inflation rate
h - expected home country inflation rate
This equation can be simplified to:

 S1  1 h 
    
1  
 S0   f 
The relative version of PPP is:
e = h - f
  S1  1 h 
    
1  
 S0   f 
 Example.
Prices in US rise by 4% per year
Prices in Germany rise by 6% per year
The current spot exchange rate S0=$1.2/Euro
What is the expected spot rate in 1 year
(S1):

S1/$1.2 = (1+0.04)/(1+0.06)
S1=$1.18
 PPP

 What is a rationale for PPP?

If inflation rate in the country is higher than in its

main trading partners (and its exchange rate
doesn’t change), its exports become less
competitive. Imports from abroad become more
price-competitive. These price changes lead to a
deficit on current account of the balance of
payment unless offset by capital and financial
flows.
Exercise
 The exchange rate between the Brazilian real
and U.S. dollar is R1.95/$. The consensus
forecast for the U.S. and Brazil inflation rates
for the next 1-year period is 2.6% and 20.0%,
respectively. How would you forecast the
exchange rate to be in one year?
Real and nominal exchange rates

Nominal exchange rate – the value of one

currency in terms of another currency
Real exchange rate – the purchasing power of
a currency relative to the purchasing power of
other currencies
 Relationship between nominal and real
exchange rates

Example. Suppose,
A car costs $50 000 in USA and
Euro 35 000 in Germany
If $1 buys 0.68 Euro on Forex market, we
find the real exchange rate, or relative
purchasing power
 The real exchange rate is given by the
equation
EX  Ph
EX r 
Pf
 EX = nominal exchange rate in foreign
currency per dollar (euro per dollar)
 Pf = foreign-currency price of goods in the
foreign country (euro price of the car in
Germany)
 Ph = domestic-currency price of domestic
goods (dollar price of the car in USA)
 Exr = real exchange rate (number of
comparable goods that domestic consumers
can get by trading a unit of domestic goods)
 Relationship between nominal and real
exchange rates

EX  Ph
EX r 
Pf

( Euro0.68 / $)  ($50000 / car )

EX r   0.97
Euro35000 / car
European car for American car
Relationship between nominal and real
exchange rates
$50 000 buys the car in USA, and 0.97 car in
Europe.
The purchasing power of a car — the real
exchange rate — is 0.97 car in Europe
relative to the same car in USA
Relationship between nominal and real
exchange rates
In reality real exchange rate usually isn’t
defined good by good.
Instead its computed from price indexes
(absolute version of PPP), which compare the
price of a group of goods in one country with
the price of a similar group of goods in
another country. The consumer price index
and the price deflator for the GDP are two
examples of price indexes.
Exercise

 A compact disc (CD) costs $16 in USA, £6 in

Britain, and ¥2000 in Japan.
 The nominal exchange rates are
$1,8/£1 and ¥120/$1.
 What are the real exchange rates in terms of
CDs (in American units of good)?
 PPP

Why PPP does not hold in practice?

•Costs of moving goods and

services
•Many services are not “tradable”
•Many goods and services are not
of the same quality across countries
 International Parity Conditions

Currencies with high rates of inflation bear

higher interest rates than currencies with

lower rates of inflation.
Irving Fisher established that in equilibrium
lenders will receive a nominal rate of interest
equal to a real interest rate plus an amount
sufficient to offset the effects of expected
inflation
 The relationship between nominal rates of
return, real rates of return and expected
inflation:

(1  i)  (1  ir )(1   )
Or

i  ir    ir  
 i  ir    ir  
i — the nominal rate of interest
ir — the real rate of return
π — the expected inflation rate
Example. The annual real rate of return in
France is 3%
 The expected annual inflation rate 8%
 What will be the nominal interest rate?

i = 0.03 + 0.08 + (0.03)(0.08) = 0.1124,

or 11.24%
Fisher argue that in the absence of
government interference and holding risk
constant, real rates of return across countries
will be equalized through the process of
arbitrage.
For ex., if real rates of return are higher in the
US than in Europe, capital will flow to the US
from Europe until an equilibrium is reached.
 Does Fisher effect exist for all the financial
instruments?

Just for short-term government securities

World finance: Liquid fuel
 The markets are enjoying a "sweet spot" in
which economic and profit forecasts are
being revised higher but the outlook for
interest rates (and thus borrowing costs)
remains on hold, thanks to subdued inflation.
On September 23rd the Federal Reserve said
that the American economy had "picked up"
but that interest rates were set to remain
"exceptionally low". The data indicate that
most developed economies have emerged
from recession.
Exercise
 Due to the integrated nature of their capital
markets, investors in both the U.S. and U.K. require
the same real interest rate, 2.5%, on their lending.
There is a consensus in capital markets that the
annual inflation rate is likely to be 3.5% in the U.S.
and 1.5% in the U.K. for the next three years. The
spot exchange rate is currently $1.50/£.
 Compute the nominal interest rate per annum in
both the U.S. and U.K., assuming that the Fisher
effect holds.
International Parity Conditions

Currencies with low interest rates are

expected to

appreciate relative to currencies with high

interest rates
 It states that difference in interest rates
between two countries should be offset by
equal, but opposite changes in the future spot
exchange rate

In equilibrium differences in interest rates

must equal the expected changes in the
spot rates of exchange. This equality is
known as the international Fisher effect or
the Fisher open hypothesis.
For example, if one year nominal interest
rates are 10% in US and 7% in France, than
IFE predicts that Euro should
International Fisher Effect:

S1  S 0 i h  i f

S0 1 if
S1 — expected future spot rate at time
period 1
S0 — current spot rate
Ih — home country nominal interest rate
If — foreign country nominal interest
rate
The relationship could be simplified to:

 S1   1  ih 
    
1 i 
 S0   f 
The justification for the IFE is that investors
must be rewarded or penalized to offset the
expected change in exchange rates.
 Example.
- One year nominal interest rates are 10% in
US and 7% in France
- Current spot exchange rate is $1.2/Euro
- The expected spot rate in 1 year:

 S1   1  0.1 
   S1  $1.23
 $1.2   1  0.07 
Conclusion: Fisher Effect and
International Fisher Effect
So differences in expected inflation rates are
equal to two things: the expected change in
spot exchange rates and the difference in
interest rates.
Discussion:Earnings: At the Mercy
of a Mercurial Dollar
USD trend

 Does strengthening of the domestic currency

mean - the strong economy?
 How currency shifts of the forth-quarter of
2008 did impact US MNCs revenues?
Discussion:Earnings: At the Mercy
of a Mercurial Dollar
 What industries are mostly hurt by a rising
dollar?
 What were good news for US companies due
to the dollar rebound?
 What economic factors and how could drive
the dollar up or down in the future?